Reason Foundation

Do Cap and Trade Programs Spur Technology Innovations?

A long-standing talking point used to promote environmental regulations is the notion that they create the impetus for the private sector to create technological innovations needed for sustained environmental improvement. But according to a new study in the journal Proceedings of the National Academy of Sciences, cap and trade regulations actually create perverse incentives for the private sector to not innovate.

According to author Margaret Taylor, a researcher at Lawrence Berkeley National Laboratory, some cap and trade programs (CTPs) have succeeded in reducing pollution but they have also reduced incentives for R&D that could produce longer-lasting and more-meaningful pollution controls.

In a pure cap and trade program, a cap is set (usually by the government) on the amount of a pollutant that firms may emit. “Allowances” are distributed to these firms, which represent the right to emit the specified amount of each pollutant. The only way a firm is allowed to exceed their allotted amount of allowances is if they purchase allowances from other firms who have successfully reduced their emissions below their own allowances. This is the “trade” in cap and trade. In effect, the buyer of another firm’s allowances is paying a negotiated amount to pollute more than they should, putting a price on the pollution. Firms with the ability to cheaply reduce emissions will do so and profit from the sale of higher value pollution allowances – thus achieving the cheapest route to reductions in pollution for everyone.

But this only works if allowances represent value, and Taylor’s research shows that in most cases (if not all) analysts wildly overestimate the worth of tradable allowances. The cap-and-trade programs Taylor studied showed extremely low allowance prices across the board. This is because firms adopted “low-hanging fruit” and other unforeseen approaches to reduce pollution in the lead-up to trading. A glut of allowances grew in response, which led firms to bank unused allowances to meet emissions restrictions in the future.

In a sense, the policy succeeds because firms found ways to reduce pollution in the cheapest manner. But Taylor’s research finds that rapid early gains have been followed by a period of stagnation – because lower-than-expected allowance prices give firms the incentive to neglect R&D because of how cheaply they can comply with the cap by hoarding allowances once easy emissions are cut.

"There are usually relatively cheap and easy things to do at the start of any new environmental policy program," said Taylor. "But if doing these things has the tradeoff of dampening the incentives for longer-term innovation, there can be a real problem, particularly when dramatic levels of technological change are needed, such as in the case of stabilizing the global climate."

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The U.S. implemented CTPs in the 90’s to deal with acid rain, which is produced mostly from sulfur dioxide (SO2) and nitrogen oxides (NOx). Under this program, companies that significantly cut SO2 and NOx emissions could sell their allowances to sources that found it too difficult or expensive to do so.

Taylor started by comparing expected prices for allowances with the prices that showed up once trading began. She found that trading for SO2 and NOx wound up between 50 and 80% of predictions. As a result, most firms simply bought allowances they did not need to stash them away for future use.

As noted above, the program worked in the sense that it incentivized industries to implement the “low-hanging fruit” approaches to emission reductions, such as switching to lower-sulfur coal and other fuel switching. But the drastic decline in the value of allowances actually led to the cancellation of pollution controls like scrubbers and other technologies thanks to the glut in allowances. Industries already in the process of updating their facilities due to existing regulations were incentivized to scrap these projects once the government introduced a cheaper alternative. These low prices also gave reason for innovators working to develop technologies outside of the industry that anticipated returns on their R&D investing would be lower than expected because of the introduction of cheap allowances. Her research also find that patent applications going to technology aimed at curbing emissions reductions of both SO2 and NOx were at their peak before the implementation of the acid gas CTP and fell to lowest levels ever once the program became operational.

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Does this mean that cap and trade programs are less desirable than the typical command-and-control style regulations? For pollutants that are genuinely harmful to humans (i.e. not greenhouse gases) and ambient in nature, cap and trade programs that truly rely on free-markets, allows flexibility, and adhere to principles of gradual change can be a much welcomed alternative to inflexible, bureaucratic, and process-oriented command-and-control regulations. However, this is another example of the imperfect nature of even the most market-based environmental regulations. Namely, that those who construct them do a terrible job predicting the future, which lead to unitended consequences that benefit no one.